14 Interest Rate and Currency Swaps.ppt

Interest rate and currency swap marketInterest rate and currency swap market

Presented by: - Vikas Singh 11/PMB/096

Chapter OutlineChapter Outline

Types of SwapsSize of the Swap MarketThe Swap BankSwap Market QuotationsInterest Rate SwapsCurrency SwapsVariations of Basic Interest Rate and Currency

SwapsRisks of Interest Rate and Currency SwapsIs the Swap Market Efficient?

Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient?










DefinitionsDefinitions

In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.

There are two types of interest rate swaps:◦Single currency interest rate swap

“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.

◦Cross-Currency interest rate swapThis is often called a currency swap; fixed for

fixed rate debt service in two (or more) currencies.

Size of the Swap MarketSize of the Swap MarketIn 2007 the notational principal of:

Interest rate swaps was $271.9 trillion USD.

Currency swaps was $12 trillion USDThe most popular currencies are:

U.S. dollarJapanese yenEuroSwiss francBritish pound sterling

The Swap BankThe Swap BankA swap bank is a generic term to describe a

financial institution that facilitates swaps between counterparties.

The swap bank can serve as either a broker or a dealer.

As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.

As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

Swap Market QuotationsSwap Market QuotationsSwap banks will tailor the terms of interest rate

and currency swaps to customers’ needs

They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

Interest Rate Swap Interest Rate Swap QuotationsQuotations

Euro-€ £ Sterling Swiss franc U.S. $Bid Ask Bid Ask Bid Ask Bid Ask

1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57

2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94

3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13

4 year 3.06 3.09 5.12 5.17 1.73 1.81 4.25 4.28

5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39

6 year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50

7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58

8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66

9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72

10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79

3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR

The convention is to quote against U.S. dollar LIBOR.

Swap QuotationsSwap Quotations

3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR

Swap Bank

Firm A

Firm B

€3.82%€3.85%

$LIBOR $LIBOR

While most swaps are quoted against “flat” dollar LIBOR, “off-market” swaps are available where one party pays LIBOR plus or minus some number.

Example of an Interest Rate Example of an Interest Rate SwapSwap

Consider firms A and B; each firm wants to borrow $40 million for 3 years.

Fixed Floating

A 5% LIBOR

B 5.50% LIBOR + .20%

Firm A wants finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate.

A has good credit and can borrow at LIBOR

Firm B wants finance an interest-rate-insensitive asset and therefore wants to borrow at a fixed rate.

B has less-than-perfect credit and can borrow at 5.5%

The swap bank quotes 5.1—5.2 against dollar LIBOR for a 3-year swap.


Firm A

5.10%

LIBOR

Bank X

Swap Bank

5.0%

If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.1—5.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR – 0.10%

A’s all-in-cost:

= 5.0% + LIBOR – 5.10% = LIBOR – 0.10%


Firm B

5.20%

Bank Y

Swap Bank LIBOR

LIBOR + .2%

If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.1—5.2 they can convert their floating rate debt into a fixed rate debt at 5.40%B’s all-in-cost:

= –LIBOR + LIBOR + 0.20% + 5.20% = 5.40%


Firm B

Firm A

5.20%5.10%

LIBOR

Swap Bank LIBOR

The Swap Bank makes 10 basis points on the deal:

The Swap Bank’s all-in-cost:

= –LIBOR + LIBOR – 5.20% + 5.10% = –0.10%


Firm B

Firm A

5.20%5.10%

Bank X

Bank Y

Swap BankLIBOR LIBOR

5.0%

LIBOR + .2%

The notional size is $40 million.The tenor is for 3 years.

A earns $40,000 per year on the swap.

B earns $40,000 per year on the swap.Swap Bank earns $40,000 per year.

What about the Principal?What about the Principal?In our “plain vanilla” interest-only interest rate

swap just given, we did not mention swapping the Notational Principal.

It could be the case that firm A exchanged principal with their lender (Bank X) and firm B exchanged principal with their outside lender, Bank Y.

Example of an Currency SwapExample of an Currency SwapFirm A is a U.S. MNC and wants to borrow €40 million for 3 years. Firm B is a French MNC and wants to borrow $60 million for 3 years

$ €

A $7% €6%

B $8% €5%

Firm A wants finance euro denominated asset in Italy and therefore wants to borrow euro.

A can borrow euro at 6%

Firm B wants finance a dollar denominated asset and therefore wants to borrow dollars.

B can borrow dollars at 8%

The current exchange rate is $1.50 = €1.00

Example of a Currency SwapExample of a Currency SwapSuppose that the Swap Bank publishes these quotes.The convention is to quote against U.S. dollar LIBOR.

Euro-€ U.S. $

Bid Ask Bid Ask

3 year 5.00 5.20 7.00 7.20

$ €

A $7% €6%

B $8% €5%

Firm A wants finance euro-denominated asset in Italy and wants to borrow euro.

A can borrow euro at 6% or they can borrow euro at 5.2% by using a currency swap.

$7.0%

Example of a Currency SwapExample of a Currency Swap

Suppose that Firm A borrows $60m at $7%; trades for € at spot.

Euro-€ U.S. $

Bid Ask Bid Ask

5.00 5.20 7.00 7.20

$ €

A $7% €6%

B $8% €5%

Firm A €5.2%

Swap Bank

Bank X

FOREX Market

LIBOR

LIBOR

$7.0%

(The convention is to quote against U.S. dollar LIBOR.)

$60m$60m €4

0mFirm A then enters in to 2 fixed for floating swaps.

$7.2%


Suppose that Firm B borrows €40m at €5%, trades for $.

Euro-€ U.S. $

Bid Ask Bid Ask

5.00 5.20 7.00 7.20

$ €

A $7% €6%

B $8% €5%

Firm B€5.0%

Bank Y

Swap Bank

FOREX Market

LIBOR

LIBOR

€40m

(The convention is to quote against U.S. dollar LIBOR.)

€5%

€40m $60m

Firm B then enters in to 2 fixed for floating swaps.


Firm B

Firm A

$7.0% $7.2%

€5.2%

Bank X

Bank Y

Swap Bank €5.0%

$7.0

% €5.0%

The notional size is $60m.The tenor is for 3 years.

Firm A earns 80 BP per year on the swap and hedges exchange rate risk.

Firm B earns 80 bp per year on the swap and hedges exchange rate risk.

Swap Bank earns 40 bp per year (20bp in $ and 20bp in €).

The QSDThe QSDThe Quality Spread Differential represents the

potential gains from the swap that can be shared between the counterparties and the swap bank.

There is no reason to presume that the gains will be shared equally.

$ €

A $7% €6%

B $8% €5%

QSD 1% – –1% = 2%

The QSD is calculated as the difference between the differences.

Comparative Advantage Comparative Advantage as the Basis for Swapsas the Basis for Swaps

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in euro.

$ €

A $7% €6%

B $8% €5%

Variations of Basic Currency Variations of Basic Currency and Interest Rate Swapsand Interest Rate SwapsCurrency Swaps

fixed for fixed fixed for floatingfloating for floatingamortizing

Interest Rate Swaps zero-for floatingfloating for floating

Risks of Interest Rate Risks of Interest Rate and Currency Swapsand Currency SwapsInterest Rate Risk

Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.

Basis RiskIf the floating rates of the two counterparties are

not pegged to the same index.Exchange rate Risk

In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Risks of Interest Rate Risks of Interest Rate and Currency Swaps and Currency Swaps (continued)(continued)Credit Risk

This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.

Mismatch RiskIt’s hard to find a counterparty that wants to

borrow the right amount of money for the right amount of time.

Sovereign RiskThe risk that a country will impose exchange rate

restrictions that will interfere with performance on the swap.

Swap Market EfficiencySwap Market EfficiencySwaps offer market completeness and that has

accounted for their existence and growth.

Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

Concluding RemarksConcluding RemarksThe growth of the swap market has been

astounding.

Swaps are off-the-books transactions.

Swaps have become an important source of revenue and risk for banks

Sample Currency Swap Sample Currency Swap ProblemProblem

A is an Italian firmA can borrow in euro at €5% fixedA prefers to borrow in dollars but faces $8% cost

B is an American firmB has already borrowed in dollars at $8½%5 years ago they issued a 15-year bondB now prefers to borrow in euro but faces €6%

costBoth firms want a 10-year maturityDevise a feasible swap that eliminates exchange

rate risk for A and B

Thank You

14 Interest Rate and Currency Swaps.ppt

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